Understanding expense ratio in mutual funds

This is a ratio that measures the per unit cost of managing a fund.

One of the parameters investors look at while choosing a mutual fund scheme or comparing it with its peers is the expense ratio charged by the fund house.

What is expense ratio?This is a ratio that measures the per unit cost of managing a fund. The figure is arrived at by dividing the fund’s total expenses by its assets under management. There are various costs the AMC incurs which forms part of the expense ratio. For example, the AMC has a fund management team which consists of highly qualified professionals who track the markets and companies in the portfolio. They make decisions to buy and sell securities to meet the objectives of the scheme. In addition, the asset management company also incurs expenses such for transfer and registrar, custodian, legal, audit fees, and fees to be paid for marketing and distribution of its products. These costs are recovered through its unit holders on a daily basis. The daily net asset values (NAVs) of a fund scheme are reported after deducting such expenses.

What is the ceiling set by the market regulator for expense ratio?At its meeting held yesterday the regulator, Sebi, has revised the expense ratio to be charged on mutual funds. The market regulator has set a ceiling for the expense ratio. It has created various slabs based on assets under management for open-end equity mutual fund schemes. For the first Rs 500 crore, they can charge 2.25%; for Rs 500-750 crore, 2%; for Rs 750-2,000 crore, 1.75%; for Rs 2,000 to Rs 5,000 crore, 1.6%; for Rs 5,000 to Rs 10,000 crore, 1.5%; for Rs 10,000 to Rs 50,000 crore reduction of 0.05% for every increase of Rs 5,000 crore; and for AUM greater than Rs 50,000 crore, 1.05%.

How does expense ratio impact fund Returns?Expense ratio indicates how much the fund charges in terms of percentage annually to manage your investment portfolio. If you invest Rs 10,000 in a fund which has an expense ratio of 2%, then it means that you need to pay Rs 200 to the fund in order to manage your money. Simply put, if a fund earns returns equal to 15% and has an expense ratio of 2%, then you would earn a return equal to 13%. A lower ratio means more profitability and a higher ratio means less profitability. Although high expense ratio impacts the fund returns, it is not necessary that high expense ratio will always give low returns.